What Did Goldman Do Wrong? Betting on ‘Library Binding’

Once upon a time long ago in a land faraway, there was a community of successful business people who wanted more books to read. They decided to pool their resources and create a brand new library.

These people founded a beautiful new library building in the center of their city. They sought the best librarian in the land, so they offered the extra incentive of fees. In addition to a salary and bonuses, their librarian could earn fees for services. They instructed their librarian to uphold two of Mr. S.R. Ranganathan’s “five laws of library science”:

A book for every reader.
A reader for every book.

Our industrious librarian immediately began making deals with both book publishers and library patrons, charging each side a fee. These deals were all based on the value of books. So these kinds of deals quickly become labeled “book derivatives,” or “BODs” for short.
Keep in mind that a derivative has no intrinsic value of its own. A derivative is founded on the promises that two or more parties to a contractual deal make to do something for each other. When push comes to shove a derivative (deal) is only as good as each party’s word. But what about the word of the “broker” of a derivative deal?

Our cutting edge librarian is the “broker” in book derivative deals. This kind of broker matches readers and books in BOD deals. So how good is our librarian’s word? Here’s where our story begins.

Fees from one side

Every week our book broker sends out an announcement to patrons describing the new books they’ve bought. There’s one new book title in particular that’s been attracting readers like hotcakes at a pancake breakfast.

Imagine a patron calls and asks our librarian to hold a copy of this popular new book. Our librarian says, “Sure, we have one in now,” and puts a copy of this book on the back shelf to hold for that patron. Our librarian broker collects a personal fee when the patron fulfills their promise and comes in for the book.

Fees from the other side

Imagine our librarian had a choice of who to buy this book title from. For this title, our book broker chose a publisher well-known for putting together cheap books with “library binding.” This is a special type of binding where the pages tend to fall out more easily after a few uses.

Yes, library binding is real. It’s used for hardbound books that are expected to sit on the shelf in a library or the bookcase of any book afficianado. Library binding serves a useful purpose. It allows book collections to be more comprehensive in spite of limited budgets. The publisher pays our book broker a fee when when the books are delivered.

Betting on library binding

Our librarian fulfilled their job description by brokering a deal where a book found its reader and a reader found their book. And, our librarian even made their library money on the deal by buying books with less-than-stellar binding. So now their library can afford to buy more books! Naturally, our book broker writes a glowing self-evaluation on how well they did their job.

Meanwhile back in the break room, employees of the library are sitting around with their cellphones out. They, their families, their friends, some of their patrons, the book’s publisher and its employees, and other interested parties have a “pool” going.

They’re all betting on whether or not the patrons of this particular new book title will be happy with the copy of the book they got. Will the copy be intact or will pages fall out over time. Our book broker too is part of this pool. Eagerly they all await to see if the library gets a flood of complaints about this particular book.

Judgment day

When caught out, our book broker librarian insists that users of the library are “sophisticated” patrons. The library’s patrons all use the library regularly. They all know what they’re getting into when they accept the librarian’s offer to hold a book for them for a fee. Our librarian says there’s no need to disclose the kinds of binding used for each title they buy. “Sophisticated readers know that some publishers use library binding.”

Our librarian sees no conflict between taking fees from both sides. Our book broker stoutly insists that under this system of market making between publishers and patrons, “most patrons get what they expect from a book when they come into the library, so all is well.” The publisher of the book in question and our librarian both protest loudly, “Library binding is legal. We’ve used it for years!”

As far as the betting pool goes, our librarian argues that the library and some of its employees have lost a little bit of money on the deal too. “Patrons aren’t the only losers,” our book broker whines.

When questioned by Congress about how their BOD library operates, our librarian bravely asserts that a book broker simply cannot be held to have a duty to each patron. “Our job as book brokers is to match readers with books. The more money we save, the more books we can buy, and the more readers we serve. If such a standard of duty to every patron were applied to us, we simply couldn’t do our jobs!”

What do you think? Do you agree? Is this how a library should work?

Three key issues for market makers of derivatives

Here’s what I see as the primary problems of Goldman Sachs’ as a market maker:

(1) fees – charging both sides of derivatives fees. How can Goldman always make derivative deals that are in the interests of both sides? Even attorneys know better than that.

(2) disclosure – assuming all clients are “sophisticated investors.” How many investors really know which derivatives are sound or what the intentions are of the particular company that makes the derivatives they buy?

(3) conflict-of-interest shorting – creating inferior products in order to bet against them. It’s one thing to bet against the thrower of the dice in a game of craps. It a whole other thing when you pick the maker of the dice being used in the game!

1 comment so far ↓

I have updated my blog with the case transcripts. Also, I have added some new comments in relation to the
Goldman Sachs Fraud case.

The new blog letter goes as follows:

I am presently in litigation with Fremont Reorganizing, Goldman Sachs dba Litton Loan Servicing, et al., (2 different cases) for about 2 years now. The main issue with the complaint is a fraudulent loan originated by Fremont in June 2006…

Note: My wife is pursuing individuals who are interested in joining her in a class action lawsuit with regards to violation of her community property rights in a wrongful foreclosure. If you are in a community property state and a spouse is not on title you may have grounds for legal action.

[NKH: Goldman’s apparently bought Litton in late 2007. Here’s the link to Bloomberg’s news site: http://www.bloomberg.com/apps/news?pid=20601087&sid=av8fOkC1HHEc&refer=home. Two recent articles on Litton are: “Subprime consumers hit at Goldman,” page 1, and Goldman’s subprime business: US consumers rage against Goldman unit,” p16 of June 16, 2010 Financial Times. Many other large banks bought home loan servicers too. They all did this in order to gauge the market for their products, such as bonds, that were based on mortgages. in March 2011 Goldman Sachs, after receiving a notice from regulators seeking information about Litton that could result in fines, decided Litton was not part of Goldman’s “core” operations, and it was thinking of selling Litton.]